Exam 15: Capital Structure Decisions: Part I

Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financing (rd). Which of the following statements is most correct?

Which of the following statements is most correct?

The graphical probability distribution of net income, when financial leverage is used, would tend to be more peaked than a distribution where no leverage is present, other things held constant.

The firm's business risk is largely determined by the financial characteristics of its industry.

What is AJC's current total market value and weighted average cost of capital?

The trade-off theory tells us that the capital structure decision involves a tradeoff between the costs of debt financing and the benefits of debt financing.

Two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT.

Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical.